Ideas for Reformulating a Volatile Fuel Market

Gary Cohn and Elizabeth DouglassTimes Staff Writers

California Atty. Gen. Bill Lockyer has spent years examining the inner workings of the state's fuel business and thinks he's found a partial solution to expensive gasoline: Every time he starts up his hybrid Toyota Prius, he figures he's conserving.

"Doing something that expands supply and reduces demand is absolutely necessary," said Lockyer, who convened a gas-price task force in 1999 and once likened the state's refiners to the Organization of the Petroleum Exporting Countries oil cartel. Two years ago, Lockyer bought his black Prius, which runs on gasoline and electricity, to show his commitment to burning less fuel.

Taming California's energy prices will require using less gasoline and diesel, making or importing more fuel or tinkering with the way refiners and retailers operate, according to interviews with two dozen economists, consumer advocates, oil executives and government officials.

Expensive gasoline is a national problem, reflecting the steep cost of crude oil. But the situation is particularly serious in California, which has some of the highest gas prices in the United States because of a series of actions by regulators, oil companies, community groups and others. Step by step over the last decade — starting with mandates for a special cleaner-burning fuel and adding in oil company mergers, community resistance to refinery expansions and unrestrained demand — the Golden State's fuel business has been transformed into a kind of dream market for oil refiners.

The strains on California's fuel sector won't be easily fixed, the experts stressed. Some ideas are likely to be painful and politically unpopular.

Take taxes, which currently add about 55 cents to California's per-gallon gasoline cost, with 18.4 cents going to the federal government and the rest to state and local governments.

"If we were smart about this, we would increase the gas tax substantially — that would reduce demand and get us back to a point at least for a while where we were able to supply our own needs for California," said Severin Borenstein, director of the University of California Energy Institute in Berkeley.

California Democrats took a different approach in April, proposing cutting the gas tax 11 cents a gallon and increasing the sales tax on everything else. Legislation has yet to be introduced.

"That's a really bad idea," Borenstein said. "Lowering the tax on gas is not a good response to the fact that we don't have enough gasoline."

"I don't think it's fair to jack up gas prices and force consumers to take it in the shorts," Nuñez said.

So it goes with most proposals to alleviate gas-price sticker shock.

And not everyone believes that drastic action is warranted. Joseph Sparano, president of the Western States Petroleum Assn., an industry trade group, said that California's fuel business worked pretty well. However, he acknowledged that some structural enhancements were needed to produce and import more petroleum and its products.

"The market's not broken, but the structure needs improvement," said Sparano, who advised easing refinery permits and expanding port fuel-importation facilities. "We need to have policies in California that promote investment, not create barriers against it," he said.

Any serious revamp, the experts agreed, must recognize the growing demand and tight supplies of the specially formulated fuel required to help clear up the state's polluted skies. Few refineries outside the state are capable of producing California gas.

The problem is both immediate and long term: A minor disruption at one of California's 13 gasoline-making refineries could immediately increase prices, and a serious one could send gas costs through the roof.

"If there was a major accident at one of the California refineries that took a refinery out of production for six months, you'd probably be dealing with gasoline prices that started with a $5," said oil economist Philip K. Verleger Jr.

The problem has been building for years and isn't going to go away as long as consumption continues to grow, according to the California Energy Commission and the California Air Resources Board.

"California faces a future of increasing petroleum dependence, supply disruptions and price volatility," the two agencies said in a 2003 report. The state Energy Commission has sent Gov. Arnold Schwarzenegger a series of recommendations to boost fuel production or reduce demand, including pressuring the federal government to require more fuel-efficient vehicles.

There have been a few signs of change, including a recent upgrade to the BP refinery in Cherry Point, Wash., to make California-grade gasoline. In addition, Paramount Petroleum Corp., a small Southern California refiner that makes asphalt, will begin producing gasoline in the next month. Still, few significant steps have been taken to address the state's nagging fuel headache. Instead, cycles of high gasoline prices have been greeted with cycles of political speechmaking, repeated calls for investigations and the creation of task forces whose recommendations have largely gathered dust.

"I see very little across the board from either party," said Michael Shames, executive director of the Utility Consumers' Action Network in San Diego.

Here are some proposed solutions:

 Limit prices or profits or otherwise regulate market activity
On Sept. 1, the nation's only cap on wholesale gasoline prices will be launched in Hawaii, an isolated market where gas often costs more than anywhere else in the United States. Hawaii's average retail price for a gallon of self-serve regular was $2.54 on Friday, compared with $2.37 in California, according to AAA, the nationwide auto club.

Under the controversial law — which is being watched closely by oil industry executives, consumer advocates and economists — Hawaii's Public Utilities Commission will set a maximum wholesale price based on weekly spot-market averages in Los Angeles, New York and the U.S. Gulf Coast.

Although the law doesn't limit retail prices, it's intended to keep a lid on what's charged at the pump while ensuring the oil industry a reasonable profit. Critics say it could result in gasoline shortages and higher prices.

"The Hawaii gas price cap is a very, very flawed idea," industry spokesman Sparano said. He added that the Hawaii law brought back memories of the gasoline price controls imposed by President Nixon in 1971.

"There were gasoline lines and prices shot up," Sparano said. The measures were lifted by President Reagan in 1981.

The architect of the Hawaii price cap law, Democratic state Sen. Ron Menor, called such talk "scare tactics."

"We think those concerns are being raised by the oil companies who from the very start have attempted to derail our gas price law," Menor said.

Consumer activists and some politicians have also suggested figuring out whether oil companies are earning too much money off consumers — a popular proposal anytime gas prices soar.

Shames of the Utility Consumers' Action Network has called on Schwarzenegger to require oil companies to disclose the quarterly profit margins for each of their California operations. Then the state should consider imposing a tax on earnings that exceed a five-year average for each company, he said in a recent letter.

In addition, there have been various efforts to boost competition in the market.

Under an Assembly bill introduced last year by Democrat Christine Kehoe, now a state senator representing San Diego, California refiners would have been required to allow their dealers to buy generic gasoline from any supplier and pay the oil companies separately for the additives that make each brand of fuel different.

Currently, dealers who sell Chevron-branded gasoline, for example, must buy their supplies from Chevron at prices set by Chevron. Dealers and consumer groups have long complained that because most of California's service stations are branded — and thus bound by contracts with refiners — the system keeps dealers from getting the best deal on fuel and allows oil companies to control pump prices without owning the stations. Kehoe and consumer advocates argued that the bill would have helped to lower prices at the pump, but the bill was opposed by the oil industry and got nowhere.

Others have suggested laws that would prohibit refining companies from owning and operating gas stations in California or from using "zone pricing," a practice in which refiners charge different wholesale prices to gas stations in neighboring areas using complex and secret formulas.

 Expand fuel production and imports
The conventional wisdom is that California's 13 gasoline-producing refineries produce almost their maximum amount of gasoline with limited prospects for major expansion. But a new report from the California Energy Commission concluded that California's refineries could produce more.

"Operators of the state's refineries generally acknowledge this potential, pointing out that land and other assets are available to expand most refinery facilities well beyond the projected refinery creep" of 0.5% higher production a year, the staff report stated, although it didn't specify how much more refiners could expand. "The ability to match or exceed future growth in clean-fuels demand is, therefore, not out of the question."

Indeed, Valero Energy Corp. has tentative plans to increase processing capacity at its refineries in Benicia and Wilmington, but it's unclear how much additional gasoline the projects might yield. "Valero wants to grow right along with [California's fuel] demand and serve the market," said Rich Marcogliese, Valero's senior vice president for refining.

Oil executive Thomas D. O'Malley said California must streamline the permitting and approval process if it wants refiners to expand.

"You cannot go and tell an oil company, or any industrial company, that you need five years to permit a project and that you have to go through all these incredible steps and get nowhere," said O'Malley, who operated several California refineries as chairman of Tosco Corp., which subsequently was sold. "We looked at it, and we wanted to do it, but the process was so cumbersome that we basically said, 'This is not going to work. We can't go with that uncertainty,' " said O'Malley, now chairman of Premcor Inc., a Connecticut refiner.

The Energy Commission is expected to recommend this month that the state simplify and speed up the permitting process for refineries, pipelines and storage facilities.

There hasn't been a new U.S. refinery built in 29 years, and the obstacles to constructing one in California are formidable: cost, complex licensing regulations, lack of good sites, environmental and safety concerns and community opposition. A $2.5-billion refinery has been proposed in Arizona, on a 1,400-acre site near the Mexican border.

The company proposing the project, Arizona Clean Fuels Yuma, recently obtained a crucial air permit and hopes to open by the end of 2009, but significant permitting and financial obstacles remain. The refinery could indirectly help boost supplies in California because it would enable California refineries, which supply much of Arizona's and Nevada's gasoline needs, to send less gasoline out of the state.

In California, imports have become a crucial source of gasoline, fuel ingredients and crude oil. But projected fuel demand increases will require more imported fuel, which will strain port capacity, according to the Energy Commission. Also, there is growing public concern over pollution and traffic congestion generated by the ports of Los Angeles and Long Beach, making expansion more difficult.

Officials at the Los Angeles and Long Beach ports said they recognized the need for expanding and upgrading facilities to handle increased petroleum imports but they also had to accommodate rapidly increasing container-cargo shipments.

 Reduce fuel use
The California Air Resources Board last year adopted rules requiring carmakers to begin producing vehicles in 2009 that emit nearly a third less pollutants than older cars, which would probably be accomplished by consuming about 30% less fuel; the automakers sued to block the effort. Separately, the California Energy Commission recommended in 2003 a statewide goal of reducing demand for gasoline and diesel fuel by 15% by 2020.The state Senate recently passed a bill requiring state agencies to reduce the rate of growth in gasoline and diesel consumption and to increase conservation and fuel efficiency and the use of alternative fuels in California, but didn't specify by how much. State agencies would take these goals into account in adopting rules and regulations. The measure has been sent to the state Assembly for consideration.

The oil industry is adamantly opposed to laws that mandate reductions in gasoline consumption. "Why would anyone want to invest in California if the market was going to be reduced by law?" Sparano said. Indeed, intensive oil company lobbying has derailed most market-changing legislation in the last several years.

Some advocate that the state do more to encourage drivers to turn to hybrid gas-electric vehicles and other fuel-efficient cars. "I'd just tax the big things off the road," energy economist Verleger said.

Consumption of today's fuels could be cut by promoting alternatives, such as hydrogen, ethanol and biodiesel, experts said.

For Lockyer, the search for fuel-market solutions has a familiar ring: Five years ago, Lockyer's task force produced a series of recommendations but little real action. With the gasoline squeeze worsening, Lockyer proposed convening an energy summit on ways to expand supplies and inviting top policymakers with the authority to bring about changes.

"We need to pull everybody together," he said, "lock them in a room somewhere, and not let them out until the conclave has produced some solid answers."